# How Much Is Your Outfit Worth?

Here's a quick guide to the bottom-line logic VCs employ when calculating what they will pay for a chunk of your business

By Gabor Garai

If you have been trying to raise money from venture capitalists, you may well be wondering: Why are they offering smaller sums for larger chunks of startups than was the case during the late 1990s? The answer is embodied in the response to a second question: How do VCs decide how much an outfit is worth? It is in professional investors' calculation of that valuation that the two key issues -- how much money for what percentage of a business? -- are determined.

Two examples will shed some light: Let's say you are trying to raise \$5 million for your technology outfit in a first round of financing. If you can convince VCs that the company is worth \$10 million, then their \$5 million investment will make the outfit worth \$15 million. Since the \$5 million investment would be equal to one-third of the postinvestment value, the VCs would feel entitled to a third of the stock. However, if the VCs decide your company is worth only \$5 million, then their \$5 million investment would make the company worth \$10 million, and entitle the investors to half the stock -- a sizable difference.

There's another wrinkle to keep in mind as you go through this process: VCs will invariably demand preferred stock, which, as its name suggests, confers preferred status for certain key events -- things like dividends or a fire sale of the company's assets. This brings us back to the original question: Before they invest, how do VCs determine if a particular company is worth \$5 million or \$10 million?

### GO FIGURE.

The short answer: If you can convince VCs that your company's worth three years to five years down the road will allow them to exit -- either via an acquisition or a public offering -- with a compounded annual return of 50-60%, you will be able to negotiate a higher preinvestment valuation.

Returning to the example we started with, let's say the technology startup seeking that \$5 million investment has current sales of \$5 million annually and, while not losing money, has yet to turn a profit. The projections say that, in three years, it will have annual sales of \$50 million and net income of \$5 million.

The startup's executives document that similar, public companies are valued at twenty times net income, which would make the startup worth \$100 million in three years. If VCs hold one-third of the company's stock, they would have realized a value of \$33.3 million, well above a 50% annual compounded rate of return. On the face of it, this particular company should be able to raise the \$5 million it seeks in exchange for one-third, or less, of its stock.

Of course, VCs won't necessarily accept your three-year revenue-and-profit projections. They'll imagine all the complications that could delay or prevent achieving those goals -- the prospect of intense and increasing competition, for example, or the possibility that market penetration will prove more difficult than anticipated.